Disclaimer: Regarding trading, it’s important to be moderate and accurate. Don’t think of it as a way that guarantees you 100% to make money—at least at the very beginning of your journey. The material below isn’t meant to promote anything, as it’s made purely for study purposes.
Trading patterns are a consistent combination of factors, events, prices volumes, graphical objects, and technical indicators, which allows traders to predict the future direction of the price with a pretty nice level of reliability.
The basic idea behind patterns is that history always repeats itself.
This means that when patterns and combinations appear, there’s a good chance that the price movement will be pretty much similar to what happened in analogous situations in the past.
But it’s worth noting that the market can still be unpredictable. In fact, this is normal, and there’s no contradiction here. A reversal pattern, for example, just indicates a high probability of price movement in the opposite direction and nothing else, so it’s impossible to predict whether this will be a trend change or just a corrective movement.
Anyways, read on. We’ll tell you all about chart patterns (and more!).
Why Chart Patterns Matter in Technical Analysis
The revelation of this or that chart figure provides insight into the likely direction of future movement, offering the potential for a “relatively” comfortable entry.
However, it’s important to note that despite this, no single form can be considered as the universal solution. The thing is, while some of them demonstrate excellent performance on certain stocks, they may just crush on others.
Basic Types of Chart Patterns
Here’s an overview of the main types of chart patterns that traders come across at some point or another. We’ll also discuss some exact examples to make things clearer.
Reversal
It’s all about the shift in the asset’s trend.
Like if the market was trending upwards, then after a reversal, the price will start to decline. The same goes the other way round. But things really change overall when the reversal happens on a weekly or monthly time frame.
Daily as well.
Short-term corrections are generally insignificant except for day traders—long-term investors should remain unfazed by these fluctuations.
This type includes samples like Head and Shoulders, Double Top/Bottom.
Continuation
These indicate a temporary lull in the trend before it continues further. Some kind of a break-signal: both profits losses are spurred on before continuing the initial movement.
This type includes samples like Triangles, Flags & Pennants.
Consolidation
When a market is stuck between support and resistance, we say it is in a state of consolidation. It literally means that there is a balance between sellers and buyers. Consolidations can be of two types: expanding and tight.
First one is formed after a failed breakout, widens the trading range, and creates potential entries at the boundaries. The second one shows low volatility and often precedes some news with significant impact, so trading is generally inadvisable here.
Anyhow, all consolidations eventually break out, initiating a new trend.
This type includes samples like Rectangles.
Most Common Chart Patterns
Head and Shoulders
The Head & Shoulders model is probably the most popular. And the most common one.
At least, in theory.
Either way, there are two versions of it: the classic and the inverted. In the first case, it means that a reversal occurs after an uptrend. In the second case, the reversal comes after a downtrend.
Simple as that.
The basic idea is pretty straightforward. The form has three peaks, with the middle one being higher than the right and left ones. When using the Head and Shoulders, you may prepare for a deal only when the second shoulder is formed on the chart and the “situation” is moving towards the neck line.
Double Top and Double Bottom
Double Top and Double Bottom illustrate two (sometimes three) tops (bottoms as well) that have been frozen at the same level.
The idea is that the price goes back to the last minimum or maximum and then breaks the next one.
And as we said, there can be a few tops—two or three. As a matter of fact, everything works the same way here. The only difference, perhaps, is with a double top. In that case, the line is broken right after the second peak.
Triangles
There are plenty of triangles:
- Symmetrical—they are formed when two lines cross towards each other, indicating the likelihood of a breakout. Happens when there’s no clear direction for the asset price.
- Ascending—they are formed by a horizontal line that coincides with resistance points and an ascending trend line that is parallel to support points.
- Descending—they are formed by a horizontal support line and a descending resistance line. Truth be told, it’s the complete opposite of the previous one since the thing literally indicates a bearish scenario.
Flags and Pennants
Flags are basically two parallel lines that can be sloped up—down, or sideways.
They happen when an uptrend or downtrend forms between support and resistance lines and suggests a potential reversal.
Let’s go into a bit more detail here.
So, a flag with an upward slope is seen as a bearish pattern, which signals a change in a downtrend. On the other hand, a flag with a downward slope indicates the start of an uptrend. And when it comes to Pennants, you’ll usually see two lines—one descending and one ascending—that eventually converge.
Although they visually resemble triangles, these are characterized by their short-term nature. That’s the key difference. Otherwise, it’s all the same as with flags.
Advanced Chart Patterns for Traders
Cup and Handle
This shows that the trend has paused, yet it will pick up again once the indicator is fully confirmed. This is a pretty advanced one, so it’s probably best for beginners to steer clear of it, as they might get confused.
Anyways, in a rising market, the Cup looks like a “U,” while the Handle looks like a short pullback on the right side.
However, this tea-party pattern also forms within a declining market, resembling the N shape (or, to be more precise, the “n” one). The Handle is a brief price pullback on the right side. Once the pattern is complete, the asset value starts to decline.
Rounding Bottom (Saucer)
Saucers usually form at the support levels, whether that’s trend lines, channels, or any other indicators.
Saucers “happens” when an item drops to a low point and then starts to climb again. The result is a U-shaped pattern, similar to a Cup, yet more “rounded” and “flat.”
And there’s no Handle. But that’s just a minor detail.
Broadening
These occur when prices move further and further away from previous highs and lows, creating two diverging lines. They also often appear after a significant rise or fall of this or that investment instrument, such as a stock, for example.
As illustrated in the chart, broadenings are represented as a series of high reversal highs and low reversal lows. That’s pretty much all of it.
How to Read Chart Patterns in Stock Trading
We’ve gone over how to analyze each one under each element. Now, we want to mention that there are also special tools you can use. You may find out more on MyIndicators—https://myindicators.ch.
But when it comes to general rules, reading charts looks something like this:
- Choose the exact graph type you want to use.
- Next, decide on the timeframe to look for. Like, if you’re opting to trade in the short term, go for days. If you’re planning to invest over the long haul, weeks, months, or years might be a better fit.
- Add indicators, such as RSI (Relative Strength Index), and MACD (Moving Average Convergence/Divergence)—if needed.
- Add volume indicator.
- Plot trend lines to show the highs and lows in price.
- Check out the volume and price direction to get a feel of what’s coming up.
How to Actually Master the Stock Patterns
Mastering patterns is crucial for effective trading. To maximize their use, traders should:
- Use their knowledge. It’s mandatory to begin with thoroughly understanding the fundamentals. One must learn to interpret them and identify various formations.
- Integrate multiple indicators. While patterns offer somewhat valuable insights, combining them with other technical matters—such as moving averages, RSI, and MACD—significantly improves prediction reliability.
- Use the multi-timeframe analysis. The idea of performing an audit across multiple timeframes (hourly, daily) to gain a holistic perspective on a market sentiment is probably not that bad. Not at all, to be perfectly honest.
- Use robust risk management. Like any trading-related thing, patterns involve inherent risks. So, one probably should implement risk-management techniques, such as setting stop-loss orders and adhering to favorable risk-reward ratios. In other words: avoid overtrading at any cost.
We’ve briefly mentioned RSI, MACD, and a few other scary technical terms that might make your hair stand on end a little. Well, we do believe that it’s important to go into these in more detail:
- RSI is the most basic oscillator imaginable. Based on the calculation of the relative rate over a given period. Among other things, it allows to predict movements in the past and provide forecasts of market behavior in the future. It itself is dynamic in the ranges from 0% to 100%, and for its calculation, the absolute growth and fall for “period name” are determined. And only then the ratio between them is found.
- MACD is a metric that allows both to gauge the strength of a trend and receive several types of signals for next trade actions. In general, MACD demonstrates the persistence and indicates some of the changes.
Lastly, we want to emphasize that while all patterns offer valuable insights and buying/selling pressures, they aren’t foolproof. So, they can be used as tools in a diversified trading strategy that includes risk management techniques like stop-loss orders and position sizing.